Equity markets got off to a rough start in 2016: broad selling pressure dragged most indices into double-digit losses by early February. Global growth concerns, energy price volatility and radical monetary policies dampened investor sentiment. Then, in mid-February, despite no substantial positive macro or fundamental news, a sharp rally began. Has the rally been driven by the return of long term bulls or is it a result of bears taking a profit? Data suggests the latter.
Our relative strength indicators are telling us to be cautious at this time.
What are some of the fundamental analysts saying?
One key theme is a large reversal in style leadership: cyclical, high volatility, low quality stocks have surged past their defensive, low volatility, high quality counterparts. As one manager suggested,
“The best performing 10% of stocks in the S&P 500 gained an average of 56.2% during this rally – these are a litany of energy and mining stocks that had been bludgeoned relentlessly and left for dead. While there is nothing to buy in these groups from a fundamental perspective, these types of rallies are usually one of the first signs that the market is bottoming. Given the lack of quality stock leadership and extreme volatility in all assets including currencies, we have remained defensive.” – Noah Blackstein, Dynamic Funds
So what is the outlook for markets? Are they bottoming? Maybe, but a sustained share price rally is hard to imagine without better support from corporate fundamentals. S&P 500 companies have already delivered four consecutive quarters of negative sales and earnings growth and continue to warn about future delivery. While this has lowered the bar on earnings expectations for future reporting periods, we believe aggressive portfolio positioning without actual earnings improvement is akin to walking across thin ice -- it can be navigated, but mistakes can result in treacherous outcomes.
Some well-respected market watchers currently suggest that in the near term the markets might have 5% upside potential, but 20% downside potential. Once again, this is a time to be very careful.
The last couple of months have been very exciting for us. The portfolios continue to evolve and this was a great opportunity to see how various investments behaved during a serious market correction. While we have been hunkering down in a more conservative stance, we have been making some significant changes to our portfolios and our process. These changes will allow us to better protect the portfolios as we enter these questionable periods in the future and will also give us greater upside potential when we get the green light from our technical indicators.
In the long run, we believe equities offer the best return potential and we are looking forward to the time when it makes sense to be fully invested again. The indicators are more neutral at this point and we will likely increase our exposure to equities shortly. We will, however, continue to be more cautious until our indicators actually turn positive.